The future of the global airline industry

The future of the global airline industry:
BY NEIL KINNOCK

(Member of the European Commission responsible for Transport)

In addressing the issue of the future for the global airline industry, I will - not surprisingly - take my starting point in Europe and reflect on some recent trends in the industry here before going on to relate those trends to the wider market and its potential.

Aviation liberalisation in the European Community developed legally over a decade and, throughout that time, it has been essential for the Commission to act to ensure that national authorities do not keep or adopt artificial barriers or arbitrary distinctions which are incompatible with the development of the internal market. That activity is ongoing - for instance, discriminatory air traffic distribution rules are not acceptable and we are therefore currently seeking various changes which would ensure that the new traffic distribution rules relating to the two Milan airports will not provide unfair market advantage for any airline (see Press Release (European Commission), IP/98/795 (9.9.98) and 804 (16.9.98)).

Activities of this sort are likely to be a continual necessity. Free markets require fair rules, firmly applied - and I am sure that the Commission will sustain that view in the future. Meanwhile, it is worth measuring developments in the European industry as liberalisation has advanced.

European air transport liberalisation:
The first striking feature is, of course, the prodigious growth in the market in Europe. Output has risen significantly in terms of passengers and passenger-kilometres, airline income has increased, the number of domestic and cross-border routes operated has expanded by more than 11% in 5 years, and the number of flights has grown by around 30% during the same period.

There has been a net increase in the number of operators, from about 130 in early 1993 to more than 160 at the beginning of this year and it is interesting and encouraging to note that, whilst in the years immediately following the first liberalisation package most new ventures were in markets served by smaller aircraft, there has since been a steady increase in the number of new operators with larger aircraft.

The competition that has increased along with growth can, of course, be measured in several ways. The market shares of the traditional carriers have decreased, particularly in their domestic markets, from 75% to 62% and the number and proportion of routes with real competition has expanded. Nearly a quarter of cross-border flights are now operated on routes with at least three competitors, whereas nearly half of domestic flights are made on routes which are operated by more than one carrier.

The real significance of such figures is, of course, partly obscured by the fact that passenger demand on most internal European routes is, so far, too low to attract more than one carrier. That will change in many cases and the increase in competition, with its beneficial effects, will obviously continue. Through legislative proposals on airport charges and by other means, we will do what we can in the Commission to promote that trend.

We will also publish, by the end of this year, a paper on air transport in which we will analyse in detail the impact of the liberalisation of the sector and will assess whether further measures are necessary at the European level in order to complete this process.

In the newly liberalised environment, all carriers are clearly committed to increased productivity and reduced costs and, consequently, progress to greater efficiency.

Airline restructuring and state aid
That feature has been particularly noteworthy amongst major carriers and it signifies welcome and substantial progress away from the inertia which characterised several operators during the decades in which they enjoyed a protected environment in domestic and in international markets.

Most of those companies have clearly had to go through a very arduous restructuring process in order to achieve conditions which can enable them to gain commercial viability and in several well known cases they have required public financial assistance with those efforts.

Commission authorisation for such state aid has always been subject to compliance with strict conditions in order to counter possible distortion of competition, to impose a requirement that the aid enables the airline to become viable within a specified period, and to apply continual monitoring of the use of the aid.

In addition, we have made clear that, in the absence of exceptional and unforeseeable circumstances which are beyond the control of the company, any aid received has to comply with the 'one time, last time' principle.

It is a matter of public record that all the airlines that have gone through this restructuring process are now performing much better, even though it is clear that some of the advance is a result of the favourable economic climate in recent years. There is no doubt, however, that most of those airlines have made progress both in increasing efficiency and in developing commercial attitudes. Even the slowest to make necessary changes is now operating a new business plan with productive effects and most of the airlines for which aid was authorised in 1994 are now seriously committed to privatisation. When I look at my agenda now and compare it with what existed when I became Transport Commissioner 3½ years ago, I believe that I can say, with justification, that the era of aviation state aids in the European Union is at its end.

In this context, I wish to say a few words about the recent Commission decision on Air France which was taken as a result of the annulment of the Commission's 1994 decision by the Court of First Instance. Those who have read the judgment will know that the Court's criticism of the Commission's decision related only to the motivation on two points. The twenty five issues of substance raised by objectors to the Commission's decision were carefully scrutinised by the Court and rejected. In those circumstances, the Commission had no legal option but to confirm the same decision by clarifying the motivation on the two specified points.

Future trends:
Against the background of liberalising and restructuring developments in Europe it is useful to ask whether there is an identifiable general trend in the commercial behaviour of carriers which gives indications for the future, and what, in particular, is evident from the evolution of the major carriers that are significantly involved in world markets.

In recognising the necessity of becoming commercially profitable, many flag carriers have clearly gone through a creditable psychological change, with the result that they are accepting that they are not suited to all markets and are consequently making strategic choices.

Having studied the behaviour of US airlines in the period since deregulation in that country, several European carriers are preferring to concentrate selectively on relatively strong bases.

That is plainly leading to a concentration at their major airports, often leaving a number of routes to and from secondary airports in the hands of smaller airlines that are taking this opportunity for growth. In some cases - as people here will know - major carriers have reached various sorts of commercial agreements with smaller carriers, whilst in other cases this retrenchment has led to increased competition in domestic markets.

In this context of concentration, there is an increasing trend to create proper hubs within Europe, organised in several incoming and outbound waves of traffic in order to maximise connecting opportunities. As in the US, it seems that this commercial choice made by the major carriers to evolve towards hub-strategies facilitates the development of point-to-point competitors on dense routes with heavy 'origin and destination' passenger demand.

There is little reason to suppose that these trends will not continue and intensify.

It is clear, however, that there are a number of systemic differences in the aviation environment of the US and the EU and one of the most important and obvious is that the smaller geographical size of the market makes it less suitable for hub tactics for purely internal transport. Indeed, it is clear that, as a consequence of the shorter average distance of flights, the degree of substitutability of connecting services is inevitably lower in Europe.

In this context, it is evident that, in many cases, the objective of hub strategies is not so much to co-ordinate air transport services within Europe as to maximise the efficiency of services to and from more distant places. Indeed, considering the size of the aircraft used in long-haul services, it makes obvious sense to try to achieve sufficient feeding and to increase the load factor, and it is plain that airline companies around the world are acting on that basis.

This need to fill large aeroplanes has inevitably led to considering the possibility of feeding the aircraft at the other end of the route, particularly in America and Asia and, of course, any reference to such changing commercial strategies in the new environment brings me to the central issue of the conclusion of strategic alliances by major carriers around the world.

Strategic alliances
Before going into more detail on the subject, I pause to register my continuing regret that it is still not possible for the objectives of alliances to be achieved by authentic mergers.

This audience is only too familiar with the reality that, while globalisation of economic activities is evident everywhere and increasingly present in the airline industry, aviation is still not a normal economic activity because the restructuring and consolidation of the airline business continues to be hampered by regulatory barriers inherited from the time before liberalisation.

EU-wide agreements with Third Countries
The interpretation of the Chicago Convention has led - as many here will know - to the conclusion of bilateral agreements which exclusively benefit the air carriers which are majority owned and effectively controlled by the nationals of the countries concerned.

Within the European Union, the Commission has argued for advance beyond this short-sighted policy based on nationality for over a decade but despite the existence of an internal aviation market, it is clear that strict bilateral restrictions still apply in the case of air transport between European cities and cities located in third countries.

The economic consequence of those conditions is obviously that European airlines do not gain the full benefit that should be available from the European internal aviation market. For every carrier, certain airports are plainly more attractive than others as bases for organising connections. So, while each US airline can have several international hubs in places as far apart as Chicago, Dallas or Miami, European airlines can only develop their international strategy from their limited home base.

In addition, the nationality clauses in the bilateral agreements effectively prevent Community carriers from acquiring, and from merging with, other European carriers. For instance, a carrier from one Member State would - to say the least - be reluctant to take over an airline from another Member State that was engaged in transport services to destinations outside Europe because the second carrier would automatically lose its portfolio of traffic rights to and from the rest of the world.

The aviation industry is, therefore, still constrained by outdated restrictions. I have consequently spent many hours in the last three years trying to explain to my colleagues in the Member States that these nationality clauses are not only legally inconsistent with the freedoms of the Common Market, but that they are also economically harmful because they preserve the fragmentation of the internal market and prevent a sound and efficient restructuring of the European aviation industry. Others obviously share my view. I note with interest, for instance, that the latest report by the CAA refers to the 'inability of the major airlines to exploit long-haul traffic rights out of other Member States in the absence of EU-wide aviation agreements with third countries'. The rational course that should be taken is plain. But old habits die hard and - whatever their private reservations about the established conventions - most Transport Ministers have so far maintained the traditional position in the Council of Ministers debates.

While the integration of the industry is seriously hampered by the existing bilateral framework in general, I must emphasise that this is particularly the case in relation to the so-called 'open skies' agreements.

These are not old regulatory barriers inherited from a distant past. They have been signed in recent years - most of them since the European internal aviation market was implemented. And, in spite of the rather evocative title 'open skies', openness is hardly a quality of the agreements when every party continues to designate its 'own' carriers, on the basis of strict nationality clauses, without regard for the fact that the European signatory is only a part of an existing aviation market with no internal barriers.

Of course, the European aviation industry is plainly and understandably trying to find other ways to reach a critical size in the global market. By entering into alliances, air carriers are able, to some extent, to overcome regulatory barriers and to offer customers better services and a larger network by combining the routes operated by partners.

I understand the circumstances producing alliances and - with necessary guarantees of competition opportunities - I can also acknowledge the potential for benefit to passengers. I have to say, however, that, in my view, in most cases alliances are only second-best solutions.

Their structure is not as sound as a real merger and the economic gains from tighter integration of the constituent airlines are relatively limited. Indeed, the importance of this sort of alliance in the aviation sector is unique simply because the governmental intervention is unique.

Obviously the Commission cannot ignore these impediments for our air-lines and our objective is to secure changes that will adapt the regulatory framework to the new requirements of our industry. This means, as a first stage, moving away from nationality clauses to a Community clause, and from bilateral negotiations to Community negotiations in order to ensure, among other things, that our carriers are capable of gaining the full potential advantages of globalisation.

I understand the motivation behind the limited deals reached at Member State level. But they fail to take the global realities into account and it is increasingly clear that only a common external policy, with firm roots in the fully liberalised internal market, can offer European air-lines the basis needed for the development of their world-wide strategies.

Regrettably, most of the Member States are still refusing to give the Community the comprehensive mandate which is necessary for negotiation of the agreements which would allow our carriers to develop such global strategies. Whether it is motivated by an atavistic desire to retain traditional but rather hollow powers or simply by a lack of vision, this attitude certainly contradicts the core interests of industry and will cause serious harm if it continues over the next few years.

This reality means that after repeated efforts to gain positive change, and after efforts to work with a restricted mandate, I have had to conclude that it is necessary to resort to legal action in order to ensure that the Community will develop a common external aviation policy. That decision, as the relevant Member States now understand, is motivated much more by concern about the disadvantages which the current arrangements will increasingly impose upon the European civil aviation industry than by legalistic pre-occupations. I can only hope, therefore, that the mixture of practical arguments and legal process will produce the necessary change without great delay.

If it does, then the European Union will have the basis of a real aviation external policy, which would put an end to the current restrictions and allow European airlines to restructure and - if they wish - to merge, so that they can achieve critical size and are able to compete more effectively on a world-wide basis. There is no sound reason why European airlines should be prevented from flying from any suitably equipped airport in the Community to any airport in a third country - and whilst that is a long-term objective which could only be reached gradually through negotiations in different bilateral or multilateral contexts, I am certain that it will be achieved.

There should be no doubt, of course, that any effective external policy will have to be based on the general principles of commercial freedom for airlines, both in terms of access and in terms of pricing. There should therefore be no regulatory intervention other than in exceptional circumstances, particularly in the event of breaches of competition law. That is the policy we have applied through the different packages of liberalisation within the Community and it is the policy that should be implemented globally.

To attain our objective of developing a genuine open market regime, it will, of course, be necessary to achieve extensive co-operation between all the governments involved in order to create a stable frame-work for ensuring fair market conditions. It is clear that the need to comply with several sets of rules imposes substantial additional costs and uncertainties on airlines, and we must therefore gain greater consistency between the policies applied by the different authorities, both within Europe and more widely. The activities of the aviation industry, consumers organisations and others in working to convince governments of the need to achieve that will, of course, continue to be essential.

The alliance cases are already clear examples that demonstrate the increasing need for co-operation between the different competition authorities on both sides of the Atlantic. A common international approach in areas like leasing, computer reservation systems or code sharing will certainly facilitate the operations of carriers in the respective markets and ultimately work to the benefit of airline users.

As I indicated earlier, I regard the development of alliances to be an inevitable consequence of regulatory regimes which effectively prohibit fully fledged mergers despite the evident need for the creation of global networks and the equally evident benefits of economies of scope, scale and density. Alliances are patently a way of gaining some of those advantages in the absence of regulatory reform and the cost reductions which alliances can make possible should be - alliance partners say will be - transferred to passengers, particularly through lower fares.

Not surprisingly, all the parties that have submitted alliance proposals to the Commission also emphasise that they facilitate connections between airports in different continents and joint marketing activities which contribute to increasing the confidence of passengers needing connecting services to distant places.

In principle, I accept those views but as alliance partners understand, the European Commission and other regulatory authorities have the duty to monitor alliances in order to try to ensure that they fulfil the declared purposes of aviation allies, bring benefits to passengers, and do not effectively reduce the competition which has emerged in recent years, following the liberalisation of the sector.

It is clear, therefore, that alliances could not be approved if they unduly restricted competition in certain markets. That is why, after a comprehensive analysis of two alliances, the Commission published a draft list of remedies which, in our view, are necessary to ensure that any benefits brought to passengers by strategic alliances are not offset by restrictions on competition. As everyone here will know, that list has been made public in order to allow competitors and indeed, any interested party to comment.

Airport slots
There has, understandably, been considerable discussion, particularly in the BA/AA case, about the number of slots that the parties would have to release in order to have the alliance authorised. It would not be fruitful to swap numbers here especially since the issue is subject to further consideration in the context of the formal procedure. I will, however, take this opportunity to underline two relevant points: First, under the terms of the Commission's decision in July, slots will only be relinquished if they cannot be obtained by competitors under the normal rules of allocation. Secondly - as I have made clear on several other occasions - the Community law as agreed by the Council of Ministers in 1993 and currently in force, does not permit the sale of slots.

As some here will know, I will, in due course, be publishing reform proposals in order to permit financial payment for slots under terms which will safeguard market entry and competition. Such legal changes are, however, not likely to be rapidly agreed and the reality that will prevail for at least another 2 or 3 years is that the sale of airport slots in the European Union is not legal.

As a final comment on alliances, I must of course refer to a point included in the publication of draft remedies.

It is widely known that the Commission has taken the view that restrictions on entry into the market that arise from the existing regulatory framework are a serious obstacle to effective competition. Whilst I understand why the airlines concerned consider that the signature of bilateral 'open skies' agreements will alleviate these obstacles, I have to express doubt about whether they will be enough to ensure a sufficient number of new entrants on the routes affected by the alliance, since most potential competitors are barred by nationality clauses.

As people here will know, for instance, in the case of BA/AA, the US Department of Transportation has referred to a risk of the irreversible loss of competition on certain routes, even if a so-called 'open skies' agreement was signed between the United States and the United Kingdom. Serious consideration should therefore be given to the possibility for other European airlines to have access to the markets affected by the alliance - and I must say that I do not think that our American friends should have any real difficulty with this if they are true to their declared 'open skies' philosophy.

Conclusion:
I conclude with a truism. It is clear that a prosperous and stable future for the global airline business will depend to a large extent on the way in which all regulators, including national authorities and the European Commission, work to ensure that the legal framework evolves with the needs of the industry. Obviously that does not mean that we have to accept any new development proposed by the industry - and the industry would not expect that, especially when some changes could have anti-competitive effects. It is crucial, however, that we have a long-term vision that is broadly aligned with the progress and change of the industry. In the case of the Commission, that vision relates to an open environment for operators on an increasingly global basis and accordingly, we will continue to make all possible efforts to ensure that aviation is freed from regulatory conventions that belong to a bygone age.

I am personally committed to that objective and I believe that, if the realities can be embraced by Member State governments it is now realistic to look forward to a global market in aviation services in which the European industry can play a decisive role.

The text of a speech by Neil Kinnock, Member of the European Commission responsible for Transport at the 12^th Annual Financial Times World Aerospace and Air Transport Conference, London, 3 September 1998.

For further information sources on air transport in Europe see Section 14.5 in 'Recent references' in each issue of European Access. See also Section 6.2.b for competition issues and Section 7.11 for transport industries.